Question

a) Write out the equation that describes the Quantity Theory of Money. Must indicate clearly what each variable in the equation means in order to earn full marks .
Based on the equation, predict what would happen to inflation in the long run:

b). if the growth rate of the velocity of money is zero and money supply grows at a faster rate than real GDP growth rate. You may use some hypothetical numbers to illustrate your answer (1.5 marks)
c). if the growth rate of the velocity of money is zero and money supply grows at a slower rate than real GDP growth rate. Use some hypothetical numbers to show (1.5 marks)
d). Based on these two scenarios (b and c) and the quantity theory of money as stated in this question, what would be a good monetary policy for the economy in the long run?

Answer 1

a) Quantity Theory of Money

The basic equation is:

MV = PY

Where, M = money supply, V = velocity of money, P = price level, Y = real GDP (total quantity of transactions)

In the long run, inflation will depend on the difference between the growth rates of money supply and real GDP, respectively.

If money supply grows faster than real GDP, inflation takes place. If real GDP grows faster than money supply, deflation takes place.

b)

Thus, prices will rise by 2%.

depends on the difference between and

c)

Thus, prices will fall by 2% (i.e. negative inflation, or deflation)

As mentioned, depends on the difference between and

d) Good monetary policy should always keep the real factors in mind. This means, policy makers should keep in mind that money supply should not be increased without understanding the consequences.

If real GDP has increased, the number of transactions will increase. More money will be required. This is when money supply can be increased.

But if more transactions are not happening, and GDP growth has stagnated, there is no point in increasing money supply.